Is it Profitable to invest in IPOs?

A company planning to do follow-on offering in the future may offer a small portion of its shares initially at huge discount in order to create positive market sentiment toward the stock.

Initial public offerings are perceived as inherently good investment opportunities because these provide the investor the chance to buy the stock at the “ground floor.”

But the truth is not all IPOs are winners. Sure, there have been IPOs in the past that have doubled or tripled shortly after listing but there are also many newly listed stocks that went downhill right from the start.

An oversubscribed IPO doesn’t always mean the stock will do well. In the same way, low demand for an IPO doesn’t mean the stock will be a loser. Investing in IPOs can be riskier than buying a stock with long trading history.

The lack of track record in the stock market makes an IPO unpredictable in many ways. There are unknown risks that come with newly listed stocks, which raise the returns that investors expect from IPOs.

Because of this, underwriters and issuers price their IPOs based on investors’ demand to make sure the final offer price is aligned with market expectations.

There are two kinds of investors in the market, the informed and the uninformed. When the market is strong and risk appetite is high, IPOs tend to be overpriced because uninformed investors dominate the allocation of the share offer, who end up losing later on.

But when market confidence is low and uncertainties abound, IPOs tend to be underpriced. Informed investors, who take up most of the allocation during this period, get discounts for taking additional risks. The higher the uncertainties, the greater is the discount.

While underpricing an IPO may have strategic benefits of creating demand, it has its own limitations. The degree of underpricing and its impact on IPO vary due to several factors.

One reason can be the portion of shares offered to the public. A company planning to do follow-on offering in the future may offer a small portion of its shares initially at huge discount in order to create positive market sentiment toward the stock.

On the other hand, a company that sells a significant portion of its equity may not be willing to give up too much value for its shares.

Another is the size of the IPO. Larger IPOs are considered less risky than the smaller ones and therefore underpricing is less compared to smaller IPOs.

Historical data of all initial public offerings in the PSE since 1992 show that there is a 52 percent positive relationship between the offer price and the size of the offer. The larger the size of the IPO, the higher is the offer price.

Lastly, the age of the issuing company may also matter. Seasoned companies that are well-known in the community offer less discounts than those that are relatively younger.

Making money from investing in IPOs depends largely on how it is priced. If the stock is priced attractively low, there is a good chance that it will make a killing once it gets listed.

An IPO that is priced too highly, on the other hand, may not provide enough room for upside and a little disappointment about the company in the future could send the stock price tumbling.

The success of underpricing an IPO is measured by how well the stock has performed on its first trading day. How much did the IPO make over its offer price?

IPO data from the PSE for the past 10 years show that newly listed stocks have 59 percent chance of closing higher on first day, gaining an average return of 7.2 percent above the offer price.

After one month, the chance of possibly sustaining an uptrend is cut to 56 percent with average cumulative gain of 12.5 percent. This trend continues to weaken to 50 percent in the following month with total cumulative returns of 13.7 percent.

Based on this experience, it would appear that the first two months is the best time to assess the long-term performance of the stock. IPOs have historical tendency to take a firmer trend either upward or downward after this period.

Investing in IPOs, just like buying any regular stock, requires research and careful assessment. IPOs may be a risky deal but can be a lucrative opportunity if managed well.

Henry Ong is a Registered Financial Planner of RFP Philippines. He is one of best selling book co-author of Money Matters. He also writes regularly as columnist for the Philippine Daily Inquirer.